"Basis" is an important income tax concept used to determine the amount of taxable income that results when you transfer an asset. The basis of a particular asset is key in considering whether to transfer that property during your lifetime or at your death. Here I will briefly explain the basics of basis and how it may affect your decision.
General Rule
Income tax “basis” is the amount a person invested in a specific asset. Your basis is equal to the amount that asset cost to acquire. By way of illustration, if you purchased a home for $300,000, your basis would be $300,000. If that home is later worth $500,000, your basis is still $300,000.
“Gain” on an asset refers to the amount you receive after sale of that asset, less the amount it cost to acquire that asset (or basis amount). So if you later sell the house for $500,000, your gain on that asset would be $200,000.
Carryover Basis
Normally, when you give an asset to someone, the person receiving the asset keeps the same basis as the person who gave the asset. This is referred to as “carryover” basis. Any gain on the asset is calculated using the gift giver’s basis. So if you give a gift of property to your child, your child would use the carryover basis amount to calculate gain. For example: if you originally paid $300,000 for your home and gave it to your daughter as a gift during your lifetime, her basis would be $300,000 regardless of the fair market value at the time of transfer. Later, if she sold the property for $700,000, her gain would be $400,000 using the basis of $300,000.
Stepped Up Basis
The basis of inherited property is generally equal to the property’s fair market value, which is established on the date of death or an alternate valuation date six months after the death. This is often referred to as a “stepped up basis”. So rather than the basis remaining at the decedent’s investment amount, the person receiving the decedent’s property gets a step up to fair market value on the date of death (or six months after). The step up creates an income tax advantage because the beneficiary will not have to pay income taxes on realized gain. Using the example above, if at the date of death the home is worth $550,000 and your daughter later sells it for $600,000, her gain would be $50,000 because her basis would be fair market value on the date of death. Alternately, property may get a “step down” in basis if the fair market value of the property is less than the investment amount.
*This discussion is intended to provide you with general information about income tax basis and does not include all of the variables in determining how your estate plan should be prepared. Before making and changes to your estate plan you should consult with your estate planning attorney to determine the best options for you and your family.
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